Recently, the most oft-asked question from investors has been ?Is this like 1997??, referring to the Asian crisis, which broadened out to other emerging markets in the following two years. This is more of an empirical question. We remember 1997 well?having conducted in-depth analysis in June of that year of financial vulnerability in various Asian markets. The analysis was based on the seminal research of Graciela Kaminsky and the now-famous Carmen Reinhart, among others. Looking back, the basics of financial vulnerability have not changed much. Using similar variables to analyse vulnerability (there is no hindsight bias) we have found that:
l Of the nine markets analysed, six (or two-thirds) are demonstrating heightened financial vulnerability?close to what we saw in mid-1997. Back in 2005-06, almost none were. To be sure, the absolute of concern/vulnerability were slightly higher in mid-1997 for almost all markets covered. While many markets appear at risk today, they are not yet at the severe levels of 1997.
l Elevated financial vulnerability is often, but not always associated with currency and/or banking crises. Singapore (surprisingly), India and Malaysia score poorly on our measure of financial vulnerability. China, Hong Kong and Indonesia are also concerning. Korea and Taiwan look less vulnerable, while Thailand is in the middle. Our financial vulnerability analysis is driven by 10 factors. Excessive real credit growth, the gap between credit growth and economic growth, rising loan-deposit ratios and elevated money multipliers?all signs of credit booms and financial liberalisation. Deteriorating current accounts, ?over-valued? currencies, rising foreign debt, especially shorter duration debt reflect international illiquidity. Weakening economic growth and falling financial stock prices are canaries in the coalmine.
l There is considerable alpha in assessing financial vulnerability in countries. In eight of the nine markets, investing during periods of heightened financial vulnerability has historically produced returns well below those in calmer, less stressed times. (Hong Kong is an exception.) Indeed, returns have almost always been negative or negligible in periods of elevated financial vulnerability. Macro-risk assessment appears to matter to equity investors.
l An improving US current account deficit is closely associated with rising emerging market financial vulnerability. An improving US current account deficit signals declining global liquidity?a problem especially for dollar-short entities, i.e. those with external deficits and/or US debt. As a risk case, we are concerned that the improving US current account balance could improve further, if the past relationship with the inflation-adjusted trade-weighted dollar is a guide. (Note: this is not our house view.) Whatever the reason?a prior weakness in the dollar, greater energy production, re-shoring of manufacturing, etc?a further narrowing in the US current account balance heightens emerging market financial vulnerability in our view, and shines a light on macro-risk.
l Barring recession, the six-month windows around Fed chairman transitions have historically been marked by higher bond yields. Asian equities have been moving closely with US tapering/interest rate expectations over the past year. Potentially higher US rates?our house view is for 3% 10-year yields by end-2013 and 4% by end-2014?have historically exposed emerging market vulnerabilities.
l The breadth of countries that are seeing the greatest impact is almost as high as mid-1997, but the intensity of the event is not quite as high as prior to start of the Asian crisis?still this is concerning in our view. Asia ex-Japan equity markets were trading at 2.2x P/B in June 1997, oblivious to the crisis. Today, they trade at 1.4x, so seem more aware of the challenging environment. Still, we are not at the deep value levels that have been seen during crises like 1994, 1997 or 2008. We agree with Michael Hartnett, our chief global investment strategist, that emerging markets should be underweight versus developed markets, recognising that there may be opportunistic trading opportunities along the way.
In India, financial vulnerability is particularly high. While the lending boom of 2002-07 is over, the consequences in terms of bad loans are only now showing up. Meanwhile, the current account deficit and fiscal deficit have widened sharply, and the money multiplier and international claims/GDP have increased substantially since 2000. In other words, there is a wide breadth of trouble in India. This needs resolute policy action; in the past, when financial vulnerability was this high, and broad?1991?the government headed by Prime Minister Narasimha Rao, and finance minister Manmohan Singh, unleashed significant reforms. With an election looming, we see that route as challenging. We estimate India could fall another 10-15% before becoming deep-value that is seen in financial crises.
What happens in the US has a disproportionate impact on Asian markets. Individually, a transition of the Fed chairmanship, tapering, and a narrower US trade/current account deficit are all challenges for these markets?together, they are markedly burdensome. In the months preceding, and immediately after a transition of the Fed chairmanship, interest rates almost always rise. The only exception was in 1970, when the 1970 recession revealed itself.
In conclusion, the combination of a change at the US Federal Reserve leadership, the onset of US monetary tightening, and a narrowing US current account deficit are likely to be significant challenges to Asian markets, in addition to structural issues like falling EBIT margins, over-investment, weak corporate governance and state intervention. The prospect of greater conflict in the Middle-East is a new concern, although it should benefit oil exporters like Russia if oil prices rise. This does not bode well for countries seeing elevated financial vulnerability.
The authors – Ajay Singh Kapur, Ritesh Samadhiya & Umesha de Silva are equity strategists, Merrill Lynch (Hong Kong)
